The Vise Continues to Tighten

We continue to read daily of the budget struggles not only at the US federal government level, but all the way down the line from the state and local governments to the essential service providers.

Tax revenues are the crucial variable in any budget formula, and they have been falling for the last two years. Consequently, the trend since then has been for authorities to not only slash services but raise fees as well.

A perfect example is the plight of the New York Metropolitan Transportation Authority (MTA), which is seen by many as a microcosm of what countless other governments and agencies are facing around the country.

The MTA runs New York City's buses, subways, commuter railroads and several major bridges and tunnels. It has already been forced to slash overnight service, lay off administrators and unionized station agents, as well as abolish some bus and subway lines. The New York State comptroller has pegged the MTA's outstanding debt at $27.5 billion, and has said debt service will hit $2.2 billion by 2013 from $1.4 billion in 2009.

Out of control spending and deficits, therefore, usually lead to higher taxes and/or raise the prices of the many goods and services consumed on a daily basis.

For many forced to pay those higher prices, headlines about deflation fly in the face of their daily reality.

But there is no denying that today we fill up our gas tanks with fewer dollars than needed just a few short years ago, and buy more stocks and real estate with the same amount of dollars.

So what gives? Why are some prices rising while others are falling?

For starters, what we see is that prices in the markets and financial economy have adjusted much quicker than certain prices in the real economy. There is a natural resistance to layoffs and deep salary cuts, for instance.

In my opinion this dichotomy is not a permanent condition and can’t go on forever. If unfolding before us are the early stages of a deflationary depression, then the price increases in certain parts of the economy are in their final hours.

That is because unemployment would continue to rise and tax revenues would fall further as the economy worsens. A point will also be reached where consumers and taxpayers will say “no more” to continued price and tax increases. At that point, government and providers at all levels will be forced into a deeper cut mode and even abolish entire departments.

Let’s also understand that the issue of government refusing to make the tough decisions, and opting to raise taxes and fees instead, has really nothing to do with inflation or deflation. That is simply a government living in the past, where the boom times that were fueled by credit inflation instilled a deep-seated and linear inflationary mindset, which bloated salaries.

It takes a little longer, but when that mindset becomes deflationary we can expect to see declines in prices across the board. Salary levels are not sacrosanct. They are one of the last dominoes to fall because the shift to conservatism and deflationary thinking takes time.

After all, bear markets do slide down a slope of hope.

This final adjustment might take longer than the free market might like. At the onset of the Great Depression, for instance, President Herbert Hoover fought tooth and nail for the maintenance of salary and employment levels, and got the industrial leaders of the time to go along with his plan.

While well intentioned, it did nothing to reverse the economy’s slide and only made matters worse, for it held salaries at artificially high levels and delayed a return to a market based equilibrium that is needed for the resumption of profitability and growth.

Fast-forward to today’s financial crisis, and the disease of deficits and too much debt has purportedly been cured by the assumption of even more debt, and an unwillingness to make the tough decisions. This is not reassuring, to say the least.

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